Understanding momentum trading, its meaning, process, and working

Trading in the stock market can be rewarding but also risky. One trading strategy that potentially allows you to capitalise on short-term price movements is momentum trading. Momentum trading aims to identify stocks that are moving significantly in one direction and take a position to ride the momentum.

Read on to understand what momentum trading is, and the ways you can trade on momentum.

• Table of contents

1. What is momentum trading?
2. How to trade on the momentum?
3. The working of momentum trading
4. Elements of momentum trading
5. Advantages of momentum trading
6. Limitations of momentum trading
7. The process of momentum trading

What is momentum trading?

Momentum trading refers to a trading strategy in which you take a position in a stock that is experiencing strong price movement in a particular direction. The goal is to enter the stock early in its price swing and exit before the momentum slows down or reverses. Momentum traders aim to capture gains generated over the short-term from the momentum already present in the stock price.

How to trade on the momentum?

• Buy high, sell higher: This approach involves identifying stocks in a strong uptrend showing upward price momentum, buying them long, and selling at a higher price as the momentum carries the stock further upwards.
• Sell short, cover lower: Here you identify stocks in a strong downtrend displaying downward price momentum, short sell them, and cover the short position at a lower price later as bearish momentum pushes the stock further down.
• Pair trading: This strategy is to buy a stock showing strong upward momentum while short selling one with downward momentum. The goal is for the long position to outperform the short position. You realise gains from the price divergence.
• Sector momentum: You can trade on momentum at the sector level by buying stocks from sectors displaying improving momentum relative to the broader market. For example, buying stocks in the IT sector when it starts outpacing the Nifty 50.

Also Read: Momentum investing: What are momentum mutual funds?

Also Read: Value investing vs. momentum investing: What is the difference?

The working of momentum trading

Momentum trading aims to capitalise on the tendency of market prices to continue moving in a given direction. But what is the logic behind this? Let's understand the key aspects of how momentum trading works.

• Price trends persist in short term: Asset prices exhibit momentum effects and short-term trending behavior. A stock showing strong upward momentum in the past few weeks is more likely to keep rising rather than suddenly reverse trend.
• Trends in motion tend to remain in motion: This principle, known as Newton's First Law, applied to trading, states that a market price already in motion tends to stay in motion until acted upon by a reversal force. Momentum traders bet on this inertial persistence of price trends.
• Other traders follow momentum: As a stock price rises, more traders notice it and jump on the upside momentum. Short sellers may also cover positions. This herding effect creates further buying pressure, propelling prices higher. The reverse dynamic happens in down trends.
• Stop losses triggered in direction of trend: As a trend gains steam, more traders set their stop losses in the opposite direction. This adds fuel to the fire when these stops are triggered in cascade.

Elements of momentum trading

Let us now understand the key concepts and metrics that form the backbone of a momentum trading strategy.

• Technical indicators of momentum: Indicators like the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), stochastic oscillator, etc. help gauge whether a stock has upward or downward price momentum.
• Accelerating price moves: The essence of momentum trading is to identify price moves that are not just directional but accelerating with increasing velocity. Metrics like ADX and parabolic SAR help identify accelerating trends.
• Volume: For a trend to sustain, trading volume needs to expand as the price moves. Rising price on increasing volume confirms upside momentum. Falling price on increasing volume shows downside momentum.
• Rate of change (ROC): The ROC indicator measures the percentage change in price over a set lookback period. A rising ROC signals uptrend momentum, while a falling ROC signals downtrend momentum.

Advantages of momentum trading

• Captures large price moves: Momentum trading allows you to profit from entire large directional price moves rather than small reversals or swings.
• Emerging trends early: Well-designed momentum signals can help identify nascent trends early on before they become obvious. This allows better risk-reward timing.
• Sharp profit potential: If properly executed, momentum trading can result in larger profits in a shorter timeframe compared to other approaches focused on buying dips or undervalued stocks.
• Can work across assets: The principles of momentum can be applied across stocks, forex, commodities, and other liquid assets. This provides more trading opportunities.
• Rules-based: Momentum trading relies on quant rules and technical indicators to identify trades. There is no room for human emotion or bias interfering with the trading process.

Limitations of momentum trading

• Vulnerable to sudden reversals: The very nature of momentum trading makes it vulnerable to sudden trend reversals that can trigger stop losses and lead to large losses.
• Requires strict discipline: Having tight stop losses and resisting the urge to overtrade are essential. Lack of discipline can wipe out returns.
• Not suitable for long term: Momentum trading focuses solely on short-term price action. It does not take into account business fundamentals or valuations.
• Higher trading frequency: More frequent trading is required to capture short-term price swings. This increases commissions and taxes.
• Need for advanced risk controls: Given the rapid pace, advanced trade management skills are a must. Without proper risk protocols, one loss can erase many previous gains.

The process of momentum trading

Step 1 - Identify stock universe: Focus on liquid stocks with adequate trading volumes. Penny stocks and thinly traded shares should be avoided.

Step 2 - Scan for momentum: Use technical indicators or chart patterns to scan for stocks exhibiting upside/downside momentum. Key metrics to analyse include RSI, MACD, ADX, volume, breakouts, etc.

Step 3 - Validate with additional signals: Confirm the momentum with other technical factors like Bollinger Bands, oscillators, moving average crossovers, etc. Look for a weight of evidence in favour of the emerging momentum.

Step 4 - Assess Risk-Reward: Evaluate the stop loss required versus profit potential and look for an attractive ratio. Consider factors like volatility, liquidity, and position sizing.

Step 5 - Enter the trade: Enter long/short positions in stocks with confirmed momentum in the intended direction. Use market orders or place limit orders just above technical breakout levels.

Step 6 - Set stop loss: Put proper stop losses in place before entry based on chart levels, volatility, and risk appetite. Trail stop losses to lock in gains as the trade moves favourably.

Step 7 - Monitor progress: Keep monitoring key momentum indicators throughout the trade to gauge if the momentum is accelerating or slowing. Be ready to exit early if the momentum stalls.

Step 8 - Exit at technical level: Exit the entire position when reversal signals appear or when a predetermined price target is reached based on momentum strength.

Conclusion

Momentum trading aims to capitalise on short-term directional price persistence in stocks by entering when emerging momentum is confirmed and exiting before reversal. It offers the advantage of sizable gains from major trend moves but also requires strict risk controls given the vulnerabilities.

While momentum trading strategies do not align directly with long-term mutual fund investing, there are some broad takeaways applicable to mutual funds as well. Having clear entry and exit rules, managing risks, avoiding emotional biases, reviewing past trades, and sticking to a process are virtues that can benefit mutual fund investors too. Adapting these positives while avoiding the excessive risks of short-term trading can lead to better investment decisions.

FAQs:

How do I calculate momentum investing?

You can calculate momentum using technical indicators like RSI and ROC. Higher RSI and rising ROC signal greater upward price momentum.

Is momentum short-term or long-term?

Momentum is a short-term strategy to profit from trends over days or weeks, not a long-term strategy.

How to find stock momentum?

Check the 20-day vs 100-day moving averages. Also see if MACD is above signal line and if uptrend line rises on the price chart.

What is a high momentum stock?

One with strong upward trend, accelerating prices, surging volumes and technical indicators pointing to upside momentum.

How is momentum used in trading?

To time entries and exits based on momentum signals. Buy on upside momentum, sell when it slows. Go short on downward momentum, cover when it weakens.

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